Prosperity Puts the Squeeze on Spreads
Talk about a tight squeeze.
Spreads between government and corporate bonds are as narrow as they’ve been in recent memory. Spreads have also compressed dramatically between U.S. Treasuries and bonds from emerging-market countries such as Mexico, Poland and Brazil.
When a corporate bond pays not much more than a Treasury issue, many investors wonder: Why risk buying corporates? True, if something goes wrong in the economy, corporate yields could soar--widening the difference between yields again--as the risk of bond defaults rises.
You don’t have that same default risk with a Treasury issue, after all.
Yet as long as investors consider the default risk in corporate bonds to be relatively low, the market may continue to regard many of those bonds, and even some emerging-market bonds, as nearly as safe as Treasuries--hence, the narrow yield spreads.
To understand why spreads are so narrow today, look no further than the last seven years of economic expansion and restructuring, bond specialists say.
Corporations have become more profitable and better able to make good on bond payments. Thanks to technological advancements, middle-management layoffs, the refinancing of high-cost debt and the booming equity markets, many of America’s corporate giants have extraordinarily healthy balance sheets.
“We’re looking at the best economic environment in a generation,” said David Capurro, who manages $500 million in short-term U.S. government bonds for the Franklin Funds in San Mateo, Calif. “These spreads are appropriate, given what we are seeing.”
In the U.S. bond market, yields on long-term AAA-rated corporate bonds, the highest-quality corporates, now average about 6.81%, according to bond indexes compiled by Bloomberg News.
That is not far above the 6.49% current yield on 10-year Treasury notes.
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What’s more, lower-quality, BBB-rated corporate bonds now average about 7.36% in yield, or just 0.87 point above the 10-year Treasury.
In the early 1990s, the BBB-rated bond yield was 2 percentage points or more above Treasuries.
In the 1980s, yields were higher and spreads were much wider as many bonds sold by not-quite-so-healthy corporate giants were perceived as much more risky than government bonds. That gave investors a better opportunity to reap high returns in corporates.
The lowest-quality junk bonds, which offered yields sometimes as much as 5 or 6 percentage points above government bonds, offered particularly good opportunities for investors.
But as default rates on junk bonds have steadily declined in the 1990s, yields have dropped dramatically, in what some junk bond specialists have called a long overdue correction.
The narrowing of spreads has occurred on “some very firm economic foundations,” Capurro said, and he predicted the condition will continue. He sees no recession on the horizon, which would naturally widen spreads because corporate default rates would be expected to surge if business activity were to weaken markedly.
Likewise, many emerging-market countries’ economies have improved significantly in recent years, lowering the risk of owning bonds of those countries. So yields have plummeted on emerging-market bonds relative to U.S. Treasury and corporate yields.
A J.P. Morgan index of emerging-market bonds pegs the current average yield at 10.57%, down from more than 20% in early 1995, after the Mexican peso devaluation jarred international markets.
Yet because of the current stability in many emerging-market countries, some bond specialists see continued opportunities in such bonds.
Fixed-income investors might consider adding such emerging-markets bond funds as Scudder Emerging Markets Income, Oppenheimer Strategic Income or Merrill Lynch World Income to their portfolios, said Olivia Barbee, an analyst at Morningstar, the Chicago-based mutual fund tracker.
Part of the appeal of such global bond funds, beyond their higher yields, is the diversification factor for investors who now are focused solely on U.S. bonds, analysts say.
On the downside, global bond funds often have high operating costs and may adopt complicated strategies.
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In addition, the aftermath of the unexpected Mexican devaluation demonstrated how volatile emerging-market bonds can be: Investors in those bonds suffered negative returns in the double digits, at least on paper, as market yields soared temporarily in 1995, devaluing older, lower-yielding bonds.
Peter Van Dyke, a managing director of the division that manages $22 billion of taxable bonds at mutual fund firm T. Rowe Price, thinks there are better opportunities closer to home these days than in emerging-market bonds.
“A laddered investor who holds bonds to maturity might want to move into Treasuries,” he said. “There’s been a great run in . . . emerging-[market] bonds already. I might hold off there.”
Capurro added that if investors are expecting an economic downturn in the near future, they might want to consider a 30-year Treasury or government-backed mortgage bonds as insulation for their portfolios. Investors would flock to such safe bonds if they perceived trouble ahead, he reasons.
Howard Marks, chairman and principal with Los Angeles-based Oaktree Capital Management, which manages $8.5 billion in bonds, said there are still some good opportunities in high-yield corporate securities.
But Marks advises investors to be mindful of the credit cycles in bonds, especially corporate junk bonds. He suggests investors “keep their eyes open,” because he believes the current benevolent economic conditions will change.
“Spreads will widen and defaults will pick up” at some point, he said. “Put a little in now and invest more when they widen,” he advises.
Of course, for many investors, bonds remain too boring to bother with. For many, the only game in town is the stock market, anyway.
“We’ve seen very little inflows into bond funds,” acknowledged John Hancock bond manger Barry Evans. “That’s not likely to change until the stock market stops advancing 20% a year. Investors don’t want to hear about a safe government bond fund that’s throwing off 6% to 8% a year.”
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Bond Returns: Less Risk, Less Reward
Yields on all types of bonds--U.S. Treasury issues, high- and low-quality U.S. corporate issues and foreign government issues--have declined sharply in the 1990s. But the big difference now, compared with recent years, is that the “spread” between yields on the highest-quality bonds (such as Treasury issues) and on lower-quality bonds has narrowed dramatically. With the healthy global economy, investors perceive less risk in lower-quality issues, so they are willing to accept lower returns. Here are quarter-end yields on 10-year U.S. Treasury notes and on indexes of high-quality U.S. corporate bonds (AAA-rated), lower-quality U.S. corporates (BBB-rated) and emerging-market foreign government bonds.
(Please see newspaper for full chart information)
J.P. Morgan emerging-markets bond index
Friday: 10.57
Generic high-yield corporate bond index
Friday: 7.36
Generic high-quality corporate bond index
Friday: 6.81
Generic 10-year Treasury rate
Friday: 6.49
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Sources: Bloomberg News, J.P. Morgan
